Did the Bush administration's move in August to resume filling the Strategic Petroleum Reserve—taking off the market a crucial amount of favored light, sweet crude supply—trigger one of the largest oil price run-ups in history? One leading petroleum economist, Philip Verleger, thinks there is no other plausible explanation why oil rocketed from the low $70s to almost $100 per barrel in November.
The Department of Energy has consistently said that the amount of oil it adds to the nation's emergency stockpile is too small to affect world prices. But in Capitol Hill testimony this week, and in a more detailed presentation Wednesday at the Peterson Institute for International Economics in Washington, D.C., Verleger argued that the amount is indeed significant because of the extraordinary premium that the market now places on cleaner crude oil—the light, sweet variety.
Verleger acknowledged that he has a reputation for being "an outlier" in his oil market analysis, often bucking mainstream views. But he says that fortunately for his theory, and unfortunately for the rest of us, there will be an opportunity to test its validity in the coming months, when the Department of Energy is going to increase the percentage of light, sweet crude it adds to the SPR from about one third to two thirds. Verleger argues that according to the calculations he's done—and he admits the results are unbelievable—it could mean the difference between $60-per-barrel and $120-per-barrel crude oil in the months ahead.
"This is an accident that does not need to occur," he says. "We are running an economic experiment we don't need to run."
The problem, as he sees it, is that light, sweet crude is now highly prized on the market, because in a program that started in 2006 and is being phased in through 2009, oil refiners are required to produce ultralow-sulfur diesel fuel for trucks, buses, and other diesel vehicles. It's much easier to refine this fuel out of light, sweet crude, which already has low sulfur. Heavy, sour crude—which is by far the majority of the oil on the market—is high in sulfur and harder to refine into a fuel that meets the new environmental standards. Heavy, sour is in surplus and cheaper than light, sweet crude.
Verleger argues that the Energy Department ought to stop stockpiling light, sweet crude, sell off what it has, and instead buy cheaper heavy, sour. It may mean that in the case of an emergency the federal government would have to relax environmental regulations, as it did after Hurricane Katrina, to allow higher-sulfur diesel back on the market temporarily, he says. But the government could buy even more oil at a better price and reduce the risk of further spiraling oil prices. "DOE's current action is needlessly risking the health of the U.S. economy," he says.
Guy Caruso, administrator of the U.S. Energy Information Administration, which doesn't set policy but analyzes the energy markets, says he is unconvinced by Verleger's analysis. "It seems to be what he's saying is that world oil prices are really hypersensitive to these very small changes in light, sweet crude," he says. He adds that Nigeria's turmoil has sometimes reduced light, sweet crude on the market by 500,000 barrels a day without such price run-ups. (The amount being added to the SPR this month totals a bit more than 32,000 barrels per day.)
But Verleger says the market may be more sensitive now than it was when Nigerian production was cut. One factor that magnified the price rise, he says, was the prevalence of "delta hedging," or the purchasing of call options by large consumers like airlines, to lock in a reasonable price for fuel. Verleger argues that the financial institutions that had written these calls were forced to buy additional futures as the oil price began to rise, thus amplifying the impact of the oil DOE took off the market. The result, in Verleger's words: "market chaos."
Plenty of theories have been thrown about for this fall's big oil price run-up—the weak dollar, recession fears, sheer speculation—but this is one that is at least worth examining closely, since it happens to be one of the few market factors we can actually control. President Bush has called for doubling the capacity of the SPR and has already taken steps to prepare for its expansion.